Ask A Banker: Stock Tips!

Hi! It's Ask a Banker! I'm a former banker, current Dealbreaker editor and occasional answerer of questions real and imagined here. This week we'll continue a mini-streak of answering actual questions submitted by actual people. Help us keep it up by sending questions to planetmoney@npr.orgwith "ask a banker" in the subject line, or ask on Twitter (@planetmoney). This week's question comes from Peter Hurley on Twitter:

Q. Does anyone make anything that beats a low-fee index fund?

There are at least two short answers to this, which are:

1. Don't ask me, and

2. No.

So this has started auspiciously.

First of all, you are asking for investment advice on the Internet, so I am required to start with the standard disclaimer to the effect of this is just for entertainment, don't try this at home, neither I nor Planet Money will be responsible if you lose all your money, etc. Let me also add the nonstandard disclaimer, which is that, even among people who might give you investment advice on the Internet, I am a really bad person to ask. My investment strategy consists mostly of lighting my money on fire. Also index funds.

But here we are on the Internet so let's try to answer Peter's question anyway. First a little explanation: An index fund is a particular kind of mutual fund. A mutual fund, in turn, is just a way to invest in a lot of stocks (or bonds, or other things) at once. Instead of buying $1,000 worth of Facebook stock, you put your $1,000 into a big pot with a lot of other people's money and a professional manager in charge of investing it. The fund manager buys stock with your money, and you make a profit (or loss) if the stocks that she buys go up (or down). Different managers have different goals and styles — some buy tech stocks, some buy emerging-market stocks, etc. — but they all are basically trying to pick good stocks and avoid bad ones, and they all charge a fee for their services, which comes out of your gains in the mutual fund.

An index fund is a mutual fund that buys all of the stocks in proportional sizes — lots of stock of big companies, less of little companies — so that when you invest $1,000 in an index fund you are just buying $1,000 worth of "the stock market." Because "buy all of the stocks and wait" is a pretty easy investing strategy, index funds usually have very low management expenses and trading costs, so it's pretty cheap to invest in them.*

So the question is: Should you just do that — buy funds that invest cheaply in the entire market — or does anyone make anything that beats that strategy?

First, here is a deceptively complex question: What do you mean by "beats"? This is complex because different people want different things from their investments, and deceptively complex because in a sense they shouldn't. Some people buy Kia Sorrentos, and others buy Porsche 911s, not because they're being defrauded but because different cars make different trade-offs that appeal to different people.

It seems like investments should be different: They just take money as input and give back money as output, so whichever investment gives back the most money is the best. For everyone.

But since figuring out in advance which investment will make the most money is very hard, people talk instead about different investments being right for different people. Often this is about the trade-off between risk and reward. Some people — because they're young and have long careers ahead of them, or because they're gamblers by nature — are willing to take large risks with the hope of achieving large returns; others — retirees, the instinctively conservative — will accept lower returns to get safety and stability.** Some people want Porsches, some want Kias; some people buy penny stocks, others buy investment-grade bonds.

This is mostly a good solution in practice though it sits above a theoretical abyss. It's surprisingly hard to know how risky things are; you have to pretty much go by past performance and expert opinion. Those are also the two things that most people use in predicting whether, say, a stock will go up, and they have a pretty terrible record there. The record of predicting riskiness is better — investment-grade bonds really do move around less than penny stocks — but it's not what you'd call perfect. The story of the financial markets is one long list of people buying things because they were boring and safe and then finding out they were terrifying and scary, whether those things were AAA mortgage-backed securities or Greek government bonds or Spanish bank preferred stocks or whatever.

That list seems to be getting longer these days. A bunch of UBS clients who invest heavily in bonds, because bonds are boring and safe, will apparently be getting letters telling them that UBS now considers their investments "aggressive." Because now bonds are risky. Respectable opinion thinks money market funds — traditionally about the most boring and conservative thing you can invest in — are the new death trap. Who knows!

This has strayed away from Peter's question a bit, but I think it's important background. If everyone knew what an investment was supposed to do — make the most money over some pre-agreed period — then we'd just go find the simple answer and say "well Manager X made 15 percent and the S&P index returned 13 percent so Manager X wins." But instead there are different risk preferences and different ways of measuring risk and different time periods over which to measure returns, so everyone who doesn't want you to index — everyone who wants to get paid to manage your money — can advertise that their fund is really good at something or other, even if the something or other isn't "making you lots of money." This is mostly legitimate — different people really do have different risk preferences, time horizons, etc. — but it also provides fertile soil for rationalization and obfuscation.

But risk preferences and rationalizations aside: Is there something that you can invest in that will predictably and consistently outperform the market?

Well ... why would there be? What makes you so special?

"Beating the market" is an obviously zero-sum proposition: every dollar of above-average returns needs to be balanced by a dollar of below-average returns; that's just what an average means. Except that in practice if you're trying to get the average return, you pretty much just buy All The Stocks — in the form of a low-cost index fund — and wait until you retire, while if you're trying to get an above-average return you're either paying some swami to manage your money or day-trading frantically or both. Swami fees, and trading commissions, subtract from your return. So everyone looking for average results gets average results; everyone looking for above-average results on average gets below-average results.

This is pretty much the most established fact in finance. It's true of mutual funds: "Nearly every study of mutual fund performance has shown that on average actively managed mutual funds after expenses underperform their respective benchmarks." It's true of hedge funds: Warren Buffett has a well-publicized bet that an S&P 500 index fund will outperform a handpicked list of hedge funds, and he's ahead so far.

But that's just on average. Can some people beat the market? Meh, sure, probably. Here are some ways:

1. Be really smart. It's possible? The jury is really, really, really out on this one. I'm a smart guy, if I do say so myself, but I'm garbage at investing. And this turns out to be true of a lot of people: They do deep research, build huge spreadsheets, write well-argued investment theses, talk persuasively about the markets, joke comfortably with CNBC anchors, and still lose lots of money. Other people seem like idiots but make lots of money. Predicting investing performance based on anything other than investing performance is surprisingly difficult.

But it turns out that predicting investing performance based on investing performance is also surprisingly difficult, because it's hard to distinguish "investing smarts" from luck. There are statistical methods for doing so — basically if enough people get lucky enough for long enough, you'd probably want to explain it as something other than luck. Those statistical methods pretty much come down on the side of luck, most of the time,*** though they can't rule out the possibility that some people really are that smart.****

2. Have inside information. There are hedge funds that hire people who seem smart and they sit around researching stocks and then buying and selling them, and some of those hedge funds actually perform really well and consistently beat the market. And now a lot of people at those hedge funds are going to jail!

Is all outperformance due to cheating and insider trading, as some cynics think? Meh, probably not. But there is at least suggestive evidence that a lot of outperformance does come from some sort of insider access, legal or otherwise.

3. Add value. This isn't relevant for you, probably; you're just some guy with a retirement fund. But a lot of good investment decisions are not about zero-sum buying and selling of shares in the hopes that you've bought the best shares, but rather about buying shares and companies whose value you can increase by something you do. This is the theory behind private equity: You buy a whole company, make it more valuable through operational improvements or financial engineering or tax arbitrage, and then sell it back at a healthy profit. And there is some evidence that private equity does outperform "the market." (Maybe.)

Similarly, Buffett is revered as a great investor, but a lot of the way he makes money is by lending his Cherry Coke-flavored halo to troubled companies. "Nothing Warren Buffett invests in can go bankrupt," the market thinks, so it doesn't, and his investments go up. Because that halo is valuable, he also tends to get great deals on his investments — deals that are not open to you. Though you can buy shares in his company.

I don't know what to tell you, Peter. The answer to your question — "does anyone make anything that beats a low-cost index fund" — is "maybe," but I can't exactly tell you what it is. So my advice to you is:

index, and

don't take my advice.

You shouldn't take my advice for the reasons I started with — you should never take financial, or really any, advice from the Internet in general, and you should never take financial, or really any, advice from me specifically.

But there's one more curious reason not to take this specific piece of advice, which is: imagine if everyone did. Index funds are a great way to piggyback off the work of the stock market: a bunch of mutual fund and hedge fund managers try, with great effort and great expense, to pick the best stocks, with the result that the stocks they like go up, the stocks they don't like go down, and capital is allocated to its highest and best uses in the economy. Meanwhile you sit around doing nothing and get the average performance of those managers, without paying their fees.

This is nice for you. But if everyone did it, who would be allocating the capital? Who would make good stocks go up and bad stocks go down?***** Someone's got to pay the costs for keeping a financial system going, Peter. I nominate you.

* Again I don't want to tell you where to invest, but just by way of example some index funds in which I happen to personally invest include the Vanguard Total Stock Market Index Fund and the SSgA S&P 500 Index Fund. You can probably find someone who'll argue passionately that one S&P 500 index fund is way better than another, but you'll have to find that yourself because feh.

Also: Many people choose to get their index funds through exchange-traded funds, or ETFs, like the SPDR S&P 500 ETF, rather than through traditional mutual funds. Again you can find passionate arguments about whether and when ETFs are better than mutual funds, but you can't find them here.

One more issue that's pretty important: If you're just going to invest in "the market," what market are you investing in? Most people use "index funds" to refer to stock index funds: They buy all the stocks, but not all the bonds (and certainly not all the things you can invest in). But all of what stocks? Big index funds invest in (1) the S&P 500 — just an index of the biggest American stocks, (2) all American stocks, (3) all stocks (or all the biggest stocks) in other countries/regions/etc., (4) all stocks in a certain line of business, (5) all stocks in the world, etc. etc. etc. Which one is right for you? I dunno. You could have a thesis — "France looks great; I'm gonna buy French index funds" — or try to go as broad as possible — "I'm a citizen of the world; I want the entire market" — or some mix or other. It turns out to be surprisingly hard to avoid making decisions.

** Other times it's about correlation, but this is a fuzzier thing to describe. Different investments tend to do well in different states of the world, so you might try to understand what states of the world correspond to what investments making money, and you should then, like, do something about that. One thing you could do about it is hedge your personal life by investing in things that will do well if other aspects of your financial life do poorly. This is a common approach among financial industry employees. Investment bankers tend to make a lot of money when markets are up, and get laid off when they're down. A lot of investment bankers therefore tend to stay the hell away from the stock market in their personal investing: Why double down? There are some financial industry employees who gamble wildly with their personal money, and then a lot of people who are 100 percent in TIPS or whatever.

*** One simple measure of this is that, beyond the fact that the average mutual fund is bad, there's the even more disturbing fact that this year's good mutual funds are unlikely to be good next year. Which strongly implies that the above-average funds just got lucky this year. Here's one version:

[O]f the 700+ funds that were in the top 25% of mutual funds as of September 2010, only 10% remained in the top 25% at the end of September 2012. In other words, only 2.5% of all actively managed mutual funds in their sample were in the top quartile in September 2010 and September 2012.

**** There are various appealing subsets of smart that are something other than "point at good stock and wait for it to go up." Bridgewater, one of the most successful hedge funds, is not so much about "buying the best stocks" as it is about building a portfolio around an interestingly specified set of risk preferences. One thing to ponder is whether picking the best stocks is easier or harder to do well consistently than is, like, understanding the direction of the global economy. Neither is particularly easy, for me anyway.